Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Reads Core PCE at 3.4 Percent
Transcript
- Lucas: So the Fed's preferred inflation gauge came out Thursday — core PCE hit 3.4 percent year-over-year for May. That matches the highest reading since October 2023. And I think the immediate question is, what does the Fed actually do with that number? Luna: Because on its face, 3.4 percent is still well above the 2 percent target. But it's not accelerating sharply either — it's just stuck. Lucas: Exactly. And the Fed has been saying all year that they need to see 'greater confidence' inflation is moving sustainably toward 2 percent. A number like this doesn't give them that confidence. But it also doesn't force them to raise rates — the effective fed funds rate has been at 3.63 since May, and the FOMC has held steady for three meetings now. Luna: So we're in this weird holding pattern where inflation is too high to declare victory, but not so high that it triggers a new tightening cycle. Lucas: Right. And the composition matters a lot here. Core PCE — that's the personal consumption expenditures price index excluding food and energy — rose 0.3 percent month-over-month in May. That's a slower pace than April's 0.4 percent. So the trend is actually marginally better. But the year-over-year figure stayed elevated because of base effects from last year. Luna: Base effects meaning we're comparing against a relatively low inflation period in mid-2023, so even moderate monthly increases can keep the annual number high. Lucas: Exactly. And the big driver right now is services. Goods prices have been pretty well behaved — even falling in some categories. But services inflation, particularly housing and healthcare, remains sticky. The housing component alone accounts for about a third of core PCE, and it's still running at around 4.5 percent annually. Luna: And that's the part the Fed has the least direct control over. Higher interest rates don't instantly lower rent — there's a lag of 12 to 18 months. So even if the Fed has done enough on the housing front, we might not see it in the data until late 2026 or early 2027. Lucas: Exactly. And that's why I think the Fed is increasingly looking at market-based inflation expectations as a cross-check. The ten-year breakeven rate — which is the difference between nominal and inflation-protected Treasury yields — has been hovering around 2.2 percent. That's down from 2.21 last week, but still above the Fed's 2 percent target. Luna: So the bond market is essentially pricing in that inflation will stay a bit above target for the next decade. That's not a disaster, but it's not the all-clear signal the Fed wants either. Lucas: Right. And I think that's the real tension beneath the surface at the Fed right now. You have one camp — the more hawkish members — looking at 3.4 percent core PCE and saying, 'We can't cut until we see a sustained decline.' Then you have another camp — including some who were previously hawkish — who argue that the economy is slowing, the labor market is softening, and that keeping rates this high for too long risks overshooting on the downside. Luna: And the data since the last meeting has been mixed. We had that weak retail sales report earlier in June, but then jobless claims remain low, and the services PMI is still expansionary. Lucas: So the Fed is data-dependent in the truest sense — the data isn't pointing clearly in one direction. And that brings us back to the core PCE number. The Fed's own forecasts from the June SEP showed the median projection for core PCE at 2.8 percent by year-end. But we're already at 3.4 percent in May, and it's been drifting upward since February. Luna: Meaning they might have to revise those forecasts higher at the July meeting. Lucas: If the June and July readings come in similarly, yes. And that would push the first rate cut even further out. The market currently prices in a first cut around November or December, with maybe one more in 2027. But if core PCE stays at 3.4 or goes higher, those expectations will shift. Luna: I want to zoom in on one component that's been getting more attention: healthcare services. That's been running hot, partly because of annual price resets in insurance premiums and provider contracts that happen at the start of the year. Lucas: Yeah, healthcare services inflation in the PCE has been running around 4 percent year-over-year. And unlike goods, where you can see supply chains easing, healthcare is driven by regulatory changes, labor costs, and demographic demand. The Fed doesn't really have a tool for that. Luna: Which raises a bigger question: if the inflation that remains is structural rather than cyclical, can the Fed actually get it back to 2 percent without causing a recession? Lucas: That's the million-dollar question. And it's one the Fed itself is grappling with internally. Chair Powell at the last press conference said they're 'prepared to maintain the current target range for longer' — which is Fed-speak for 'we're not cutting anytime soon.' But he also acknowledged that the economy is in a 'new phase' where the relationship between tight labor markets and inflation might be different than in past cycles. Luna: That's a subtle but important shift. They're not saying inflation is transitory anymore, but they're also not saying it's permanently higher. They're essentially admitting uncertainty. Lucas: And that uncertainty is why I think the market's reaction to the 3.4 percent print was actually pretty muted. The S&P 500 was up 0.9 percent in the five days through today, the Dow up 1.1 percent. Bonds rallied a bit — the ten-year yield fell to 4.37, down about 2.7 percent over the week. Luna: So the market is essentially saying, 'We see the inflation data, but we also see the economy slowing, and we think the Fed will eventually cut.' Lucas: Exactly. And the bond market is pricing in that the next move is a cut, not a hike. The two-year yield, which is more sensitive to Fed policy, is at 3.68 — that's only about 5 basis points above the effective fed funds rate. That's a very flat curve, suggesting the market expects rates to stay around here or go lower. Luna: So the Fed is stuck between a core PCE that's too high and a market that's already betting on cuts. That's not an easy place to communicate from. Lucas: It really isn't. And look, this kind of deep dive into how the Fed actually reads a single data point — it's the sort of thing we love to unpack here. And honestly, the reason we can spend the time on it is that this show is listener-supported. We don't run ads, we don't have a corporate sponsor. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's what funds the research and production for episodes like this. Luna: Yeah, it's a small group, but it makes a big difference. It keeps us independent, keeps us focused on what's actually interesting rather than what an advertiser might want. Lucas: Right. So if you've been getting value from these conversations, that's the way to keep them going. But let's get back to the inflation picture — because there's another layer here that I think is underappreciated. Luna: What's that? Lucas: The global disinflation story. We've seen inflation fall sharply in the euro area and in parts of Asia. But the US core PCE is actually higher than the euro area core HICP now. That's unusual. For most of the past two years, US inflation was lower than Europe's. Now it's the opposite. Luna: And that has implications for the dollar and for trade. A stronger dollar can help contain import prices, but it also makes US exports more expensive and can weigh on growth. Lucas: Right. And the Fed has started to mention international spillovers more explicitly in recent minutes. The May FOMC minutes noted that 'global disinflation could help reinforce the domestic disinflation process' — but also that 'geopolitical risks could push in the opposite direction.' That's a reference to things like the Strait of Hormuz situation, where shipping is still fragile despite the recent us iran deal. Luna: So even if domestic demand cools, energy price shocks could reignite inflation. The Fed is essentially managing multiple risks simultaneously. Lucas: And that's why I think the 3.4 percent core PCE number is less of a signal about the past and more of a signal about the complexity of the present. It's not just one number — it's a reflection of housing dynamics, healthcare costs, global energy markets, and the lagged effects of monetary policy. Luna: So when we hear 'core PCE at 3.4 percent,' we should be thinking about all those layers, not just whether it's above or below 2 percent. Lucas: Exactly. And that's what we'll be watching as we head into the July FOMC meeting. The question isn't just 'will they cut?' — it's 'what would it take for them to feel confident enough to cut?' And right now, the answer seems to be: a sustained period of monthly core PCE readings at 0.2 percent or lower. May's 0.3 percent was better than April's 0.4, but it's not there yet. Luna: So we're looking at a few more months of patience, at least. Lucas: Barring a sharp downturn in the labor market or a major geopolitical shock, yes. The Fed is in wait and see mode, and 3.4 percent core PCE is the reason why.